When the calendar pages turned over into 2018, my take on the year was that for stocks the first half would be much like 2017: Despite rising interest rates from the Federal Reserve, there was enough earnings growth to move stocks up even from near record highs. The bond market would be more problematic with those interest rate increases keeping downward pressure on bond prices and upward pressure on bond yields. With inflation still relatively quiescent, though, the downward trend in bond prices would be relatively gradual.
It was the second half of the year that investors had to worry about, I thought then. By that time companies would have recorded much of the increase in earnings growth rates delivered by the Tax Cuts and Jobs Act. The economic recovery, already the second longest on record by the beginning of 2018, would be even longer in the tooth. Looking ahead into 2019, as analysts would start to do when they got to within six months of that turnover, they’d see companies that weren’t getting the year over year one-time boost in earnings growth rates that the Tax Cuts and Jobs Act had delivered in 2018. My reading was that markets would start to worry about earnings growth rates for 2019 in the second half of 2018. That would leave markets nervous enough to react with heightened volatility to every news headline.
Now my reading is that the worries about growth will hit sooner in 2018–which will result in more volatile markets with less oomph (a term of statistical measurement) to upward trends and more downside risk on headline news. When in 2018 will that happen? I think it’s going on right now.
Here’s what I see.
First, a general slippage in economic growth. We’re seeing it from China where the government has set a growth target of 6.5% instead of last year’s 6.9%. We’re seeing it–in all probability–in the United States where the Federal Reserve is raising interest rates and where the first Trump tariffs on steel and aluminum are projected to cut GDP growth by 0.2 percentage points, Barclays estimates. Don’t get all excited by the February jobs number released today–remember the jobs survey looks backward so this number doesn’t reflect either the effects of the tariffs that go into effect in two weeks or the effects of the likely March 21 interest rate increase. This slippage in the rate of economic growth wouldn’t matter so much to financial markets except that so many assets are trading near all time highs.
Second, the rise in what I call “Who knows?” (Or if you want you could say “An increase in the uncertainty of the potential distribution of results.”) Inflation seems to be on an upward trend in the United States but for how long and to what end rate? Who knows? right now. Comparing the spread between the yield on the plain-vanilla 2-year Treasury note and the 2-year inflation protected note, it looks like the bond market is anticipating a pick up in CPI inflation to around 2% (which implies a below 2% inflation rate by the Fed’s preferred PCE inflation measure) in the near term but believes that the increase will be transitory. In this view the Federal Reserve won’t need to go into full inflation-fighting, interest-rate-raising mode. But is the market correct? Who knows? Especially since the inflation rate is sensitive to increases in the price of imported raw materials and goods as a result of tariff increases. The dollar has been falling lately, which has helped support U.S. stocks. How long will that trend last? There are recent signs that the dollar is gaining strength. U.S. bond yields have held up surprisingly well considering the huge amounts of debt that the Treasury has sold (and has yet to sell.) Some of this, though, is a result of investors ad traders seeking the safety of the Treasury market as financial market volatility moves up a bit. How long will these flows into Treasuries work to temper any rise in yield? Who knows. All these “Who knows?” scenarios are adding to uncertainty in the market–which is reflected in a somewhat higher reading on the CBOE S&P 500 Volatility Index (VIX). At a level of 15.23 today, March 8, the VIX is still well below its long-term average of 17-19. But it is certainly significantly above the 10-12 range that it has occupied for much of the last two years.
Third, the wild cards that we started with at the beginning of 2018 remain wild cards two-and-a-half months later. The Federal Reserve still seems to think that reducing the size of its balance sheet would be a good thing–but hasn’t said much about the issue lately in the midst of the battles over tax cuts, tariffs, and budget deficits. The European Central Bank removed its bias toward easing in its last statement, which could be a sign that it’s thinking about ending its program of bond purchases relatively soon (September?). OPEC seems inclined to cut more production in an effort to push oil prices to $70 a barrel, but it’s not clear how much opposition there is to that move. Nor is it clear that OPEC has the power to do much of anything to raise oil prices in the face of projected increases in U.S. oil production. (Higher oil prices would be a drag on growth.)
And fourth, we simply don’t know whether the tariff increases that President Trump signed on Thursday will turn out to be bargaining chips in trade negotiations or the beginning of a wider global trade war.
The earnings growth picture for 2018 is so strong (thanks to corporate tax cuts) that it remains hard for me to see this market pulling back in a major way in the first half of the year. As of March 1, Yardeni Research calculated that Wall Street analysts were looking for 17.3% year over year earnings growth in the first quarter; 19.7% in the second quarter; 21.5% in the third quarter and 16.9% in the fourth quarter.
But given all these other factors and the way they seem to be developing in 2018, I am more cautious about controlling risk than I was the beginning of the year; I have less belief that the global economy is strong enough to lift all boats; and I think that the dangers of something disappointing current expectations are higher.
I’ll be making some portfolio moves over the next week or two to adjust my holdings to this slightly more negative point of view for the first half of 2018.